And far from me to encourage you onto a crowded trade – the position makes sense.

There are plenty of assets trading at 60-70c on the dollar that sit on bank balance sheets at much higher prices. If you force the banks to recognise the assets at 70c on the dollar they are amazingly insolvent.

So either

(a) the assets are underpriced, or

(b) the banks are overpriced or

(c) both.

Long junky loans short financial institutions is just an old fashioned arbitrage – and the few unimpaired arb funds (eg Paulson) are making hay...

Are the junky assets really underpriced in the market?

There are plenty of assets trading at 60 cents on the dollar. Diversified pools of mortgages (admittedly less-than-prime pools) often seem to trade at this level. AAA strips against those pools are often 70c in the dollar and where 12 percent of the assets need to go bad before you bear any loss. Implicitly there needs to be 40 percent losses before you lose money on these investments.

I know it is bad out there – but 40 percent losses imply worse than 60 percent defaults with 60 percent loss given default. It is simply not going to happen on a widespread basis (though I can show you individual securitisations that are worse than this).

So why don’t people bid up the price of the junky assets? Well some are – see the Paulson letter – and he has made good money doing things like that.

But there is a return problem. Some of these assets are quite long dated – you might get paid over ten years. And meanwhile you get say 10/7 times the AAA yield (the stuff is trading at 70c in the dollar) and it might pay 85 cents in another 10 years – so you get nearly another 2% per annum in carry.

Well 10/7 times treasuries isn’t very much – less than 4% and nearly 2% carry – and whoa you have an asset on which you won’t lose money indeed on which you probably will make five percent.

That really excites me. Asset prices are way down – this crash might be the investment opportunity of a lifetime – and I have a smorgasboard of assets to chose from on which I will not lose money over the long term – indeed on which I might make 5% per annum.

I am just thrilled.

So how are those assets really? Underpriced but hardly exciting. To be exciting they have to be insanely underpriced. There are a few insanely underpriced assets out there, but John Paulson (Paulson funds) won’t tell you what they are. And even then they are not that exciting.

No – to be exciting you need to borrow against them. You need to be able to use leverage. Cheap leverage. Lots of leverage. And it can’t be margin loans or the like – because the asset prices are so volatile that your funding might go away.

But – with permanent cheap funding at government rates it should be profitable to buy those assets. Seven to one levered at government rates (which are a couple of percent) the returns will be spectacular.

So if the Geithner plan is to attract say one hundred and fifty billion of private risk capital and allow it permanent and secure access to say a trillion dollars of government money at a government rates then hey – I am in. (I would require the interest rate risk be matched too.)

It would be a pretty big gift from the government – as nobody – a good bank or a bad bank – can borrow at the same (extraordinarily low) rate as the US Treasury. But as a plan it might just work. And because 150 billion of real private spondulicks is at risk there are some pretty strong incentives for the private sector manager to get it right.

Well who should be the private sector manager?

I don’t know. Most of them won’t work for a $500 thousand dollar salary. And that is problematic.

But – hey its my civic duty. I will do it.

Yes – you heard me, I would do it for a $500K salary. And no base fees – and a very small performance fee. Admittedly the very small performance fee will be on a very large amount of money – and with all that cheap government leverage it might leave me as rich as Croesus – say Bob Rubin rich. Indeed as the underpriced assets are common and the only problem is the inability to lever them – I should make an absolute killing if Mr Geithner will give me enough cheap, matched and permanent funding.

Indeed I would never bother with this fund I am setting up. I would get my original clients together and raise a few hundred million of private money to start the bail out fund. I will even put in most my own net worth.

13 comments:

If Treasury has to put up 6/7'ths of the cash, why involve the private sector at all? Hire a couple of managers, have Treasury put up 7/7'ths of the cash and run the trade for the benefit of the taxpayers. Let the managers make a killing, but run 95% of the profits back into the Treasury to pay for defaults on other debt the Fed is back-stopping.

I'm a pointy-headed public policy professor in the U.S., and the topics you address are far afield from my area of expertise, but for what it's worth, I find your blog incredibly informative and enlightening. I've been reading it for months. You're not infallible of course, but you really know what you are talking about. I feel like an ethnographer who somehow chanced into recruiting the sharpest and most street-wise informant on the block.

The problem is that you will only take the deals profitable to you and not take the really toxic stuff from the banks. Hence while you would make a killing you would not solve the real problem. Now try again.

Presumably the fact that these loans are underpriced in the market is how UBS can reclassify USD 15.8 Bn of them from trading to held to maturity and record an impairment of only USD 1.2 Bn, while telling us that if they'd stayed in the trading book and been marked to market would see their value drop by USD 4.2 Bn?

see slide 25 of their results presentation yesterday.

Incidentally, when you do start this fund, I'm sure you'll save a little space for your loyal blog following?

At least the plan will be mechanism for valuing the assets, which has been the main sticking point up to this point. Once the results of the private sales are in it should be easy to determine which banks are solvent and which are not, so the feds can move in and liquidate the insolvent ones.

John: This is already out there...look at TALF - FRBNY has set preliminary collateral haircuts for subprime AAA bank card ABS paper at 10% for 5 yr WAL...pricing is not as cheap - L + 100bps, but more leverage is available...

Northern Calif property prices greater then 500K range today and probably 300K in the future will fall 80% to peak value. Median household income is around 70K it doesn't take much to figure out that RE inflation coupled with selling every 5 to 7 years combined with high refi activity is what keeps people in these higher priced tier houses. The pool of buyers for these homes based on 20% down and actual income to support the monthly payments is tiny relative to the number of properties forsale.The dot.com bubble along with 30 years of inflated RE values in Northern Calif has created a financial storm that will sweep many into the BK courts.Good luck on your investment!!

There are a couple of problems with being long distressed debt: 1) you are also long the US dollar 2) you are vulnerable to a burst of high inflation. The dollar has strengthened lately and we're more worried about deflation right now, but you can hardly count on either of those things if, as you mention, some of that distressed debt is long-dated (10 years or more).

It's not clear that being short banks fully hedges you against this. Perhaps banks might even benefit from inflation (their own convertible debt either melts away or turns into equity; their Treasury loans become easier to repay).

I may be naive, but couldn't this arb go pear-shaped in some altogether plausible scenarios?

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